FM11 Ch 14 Financial Planning and Forecasting Pro Forma Financial Statements

Steps in Financial ForecastingForecast sales Project the assets needed to support sales Project internally generated funds Project outside funds needed Decide how to raise funds Se

Financial Planning and Pro Forma Statements

Three important uses:

Forecast the amount of external financing that will be required

Evaluate the impact that changes

in the operating plan have on the value of the firm

Set appropriate targets for

compensation plans

Steps in Financial Forecasting

Forecast sales

Project the assets needed to support sales

Project internally generated funds

Project outside funds needed

Decide how to raise funds

See effects of plan on ratios and

stock price

2004 Balance Sheet

(Millions of $)

Cash & sec $ 20 Accts pay &

accruals $ 100 Accounts rec 240 Notes payable 100 Inventories 240 Total CL $ 200 Total CA $ 500 L-T debt 100

Common stk 500 Net fixed

assets Retained earnings 200 Total assets $1,000 Total claims $1,000

500

2004 Income Statement

(Millions of $)

Less: COGS (60%) 1,200.00 SGA costs 700.00

Interest 10.00

Taxes (40%) 36.00 Net income $ 54.00 Dividends (40%) $21.60

AFN (Additional Funds Needed):

Key Assumptions

 Operating at full capacity in 2004.

 Each type of asset grows proportionally

with sales.

 Payables and accruals grow proportionally

with sales.

 2004 profit margin ($54/$2,000 = 2.70%)

and payout (40%) will be maintained

 Sales are expected to increase by $500

million.

Definitions of Variables in AFN

A*/S 0 : assets required to support sales; called capital intensity ratio.

S: increase in sales.

L*/S 0 : spontaneous liabilities ratio

M: profit margin (Net income/sales)

RR: retention ratio; percent of net income not paid as dividend.

Assets must increase by $250 million What is the AFN, based on the AFN

How would increases in these items

affect the AFN?

Higher sales:

Increases asset requirements,

increases AFN.

Higher dividend payout ratio:

Reduces funds available

internally, increases AFN.

(More…)

Higher profit margin:

Increases funds available

internally, decreases AFN.

Higher capital intensity ratio, A*/S 0 :

Increases asset requirements,

increases AFN.

Pay suppliers sooner:

Decreases spontaneous liabilities, increases AFN.

Projecting Pro Forma Statements with

the Percent of Sales Method

Project sales based on forecasted

growth rate in sales

Forecast some items as a percent of the forecasted sales

Costs

Accounts receivable (More )

Items as percent of sales (Continued )

Inventories

Net fixed assets

Choose other items

Debt

Dividend policy (which determines retained earnings)

Sources of Financing Needed to

Support Asset Requirements

Given the previous assumptions and choices, we can estimate:

Required assets to support sales

Specified sources of financing

Additional funds needed (AFN) is:

Required assets minus specified sources of financing

Pay off debt.

Buy back stock.

Buy short-term investments.

How to Forecast Interest Expense

Interest expense is actually based on the daily balance of debt during the year.

There are three ways to approximate interest expense Base it on:

Debt at end of year

Debt at beginning of year

Average of beginning and ending debt

More…

Basing Interest Expense

on Debt at End of Year

Will over-estimate interest expense if debt is added throughout the year

instead of all on January 1

Causes circularity called financial

feedback: more debt causes more

interest, which reduces net income, which reduces retained earnings,

which causes more debt, etc.

More…

Basing Interest Expense

on Debt at Beginning of Year

Will under-estimate interest expense

if debt is added throughout the year instead of all on December 31

But doesn’t cause problem of

circularity.

More…

Basing Interest Expense on Average of

Beginning and Ending Debt

Will accurately estimate the interest payments if debt is added smoothly throughout the year

But has problem of circularity.

More…

A Solution that Balances Accuracy and

See Ch 14 Mini Case Feedback.xls

for an example basing interest

expense on average debt.

Percent of Sales: Inputs

Other Inputs

Growth factor in sales (g) 1.25

2005 Forecasted Income Statement

2004 Factor 1st Pass 2005 Sales $2,000 g=1.25 $2,500.0

Less: COGS Pct= 60% 1,500.0 SGA Pct= 35% 875.0

2005 Balance Sheet (Assets) Forecasted assets are a percent of forecasted sales.

Factor 2005 Cas

h

Pct= 1% $25.0 Accts rec. Pct= 12% 300.0

Pct= 12% 300.0 Total

2005 Preliminary Balance Sheet (Claims)

*From forecasted income statement.

2004 Factor Without AFN AP/accruals Pct= 5% $125.0

NWC must have the assets to make

forecasted sales, and so it needs an

equal amount of financing So, we must secure another $187.2 of financing.

Assumptions about How AFN Will

How will the AFN be financed?

Additional notes payable =

0.5 ($187.2) = $93.6.

Additional L-T debt =

0.5 ($187.2) = $93.6.

2005 Balance Sheet (Claims)

w/o AFN AFN With AFN

Equation method assumes a

constant profit margin.

Pro forma method is more flexible More important, it allows different items to grow at different rates.

Equation AFN = $184.5

vs

Pro Forma AFN = $187.2.

Why are they different?

Forecasted Ratios

2004 2005(E) Industry

Profit Margin 2.70% 2.52% 4.00% ROE 7.71% 8.54% 15.60% DSO (days) 43.80 43.80 32.00 Inv turnover 8.33x 8.33x 11.00x

FA turnover 4.00x 4.00x 5.00x Debt ratio 30.00% 40.98% 36.00% TIE 10.00x 6.25x 9.40x Current ratio 2.50x 1.96x 3.00x

What are the forecasted free cash flow and ROIC?

2004 2005(E)

(CA - AP & accruals)

(Net op WC + net FA)

Suppose in 2004 fixed assets had been

operated at only 75% of capacity.

With the existing fixed assets, sales could be $2,667 Since sales are

forecasted at only $2,500, no new

fixed assets are needed

Capacity sales = Actual sales

% of capacity

= = $2,667 $2,000

0.75

How would the excess capacity

situation affect the 2005 AFN?

The previously projected increase in fixed assets was $125.

Since no new fixed assets will be

needed, AFN will fall by $125, to

$187.2 - $125 = $62.2.

Sales 0

ratio shows economies of scale Going from S = $0

to S = $2,000 requires $1,000 of assets Next $500 of

sales requires only $100 of assets.

Base Stock



Sales 1,000 2,000

500

A/S changes if assets are lumpy Generally will have excess capacity, but eventually a small S leads to a large A.

500

1,000

1,500

the AFN

forecast.

Excess capacity: lowers AFN.

Economies of scale: leads to proportional asset increases.

less-than-Lumpy assets: leads to large periodic AFN requirements, recurring excess

capacity.